Banks: Too big to be liable

Limited liability was a big idea with big benefits. It immunized entrepreneurs from the failures of the companies they set up. If the company went bankrupt, their personal assets were safe.

In the nineteenth century that legal principle was established in most advanced economies, allowing businesses to take the kinds of risks that made the dramatic expansion of our wealth and prosperity possible. Less risk meant more profits for owners, but it also led to greater economic development, increased use of capital, as well as more jobs. It was a win-win idea.

But it may have reached a limit with banks that are too big to fail. If big banks need to be insured against failure to protect the economy, what recourse is there to ensure against the "moral hazard" of allowing banks to take excessive risks. What could make bankers more prudent? We have legal recourse in cases of outright fraud or malfeasance, but what about bad judgment, or carelessness, or indifference? What penalty for just plain stupidity?

Shiela Bair, former Chair of the FDIC in the US, the agency responsible for insuring bank deposits, recently urged regulators to write rules requiring executives and boards to be "personally accountable for monitoring and compliance" of the institutions they oversee.

Interviewed by Gretchen Morgenson of The New York Times about how it could be done, Bair said: "There should be personal certifications and, at a minimum, civil penalties assessed by the banking regulators against the boards and management, as well as compensation clawbacks if there are losses to the organization because of proprietary trading. Regulators can't run these financial institutions for the management." (See, "The Fattest or the Fittest.")

As Bair said, the regulators can't run the banks. If they did, they would cease to be regulators and turn into bankers. On the other hand, owners are protected by limited liability. That leaves management, as Bair proposed. Reminded about the strong opposition to such an idea, she exclaimed in exasperation: "What in the world are they being paid for?"

Good question. One has to wonder why it isn't more obvious to everyone else?

There seems to be an unconscious principle for managers, analogous to limited liability for shareholders, that they can't be punished for their mistakes. They can lose their jobs, to be sure, and they can be prosecuted for breaking the law, but if they fall asleep on the job that's just too bad. Nothing can be done.